Private Groups: Avoiding an ATO review or audit- Preparing for lodgment
The period between the end of the financial year (30 June) and lodgment of the income tax return is a critical time to revisit key events and material transactions in your business to determine how they are to be reported for tax purposes.
Avoiding that ‘knock on the door’
In recent years, the ATO has been taking a particular interest in tax governance and tax decision-making. Having the right tax processes in place and paying attention to your tax governance ensures that what you put down and sign off on in your tax return is robust and defensible.
The expansion of and greater reliance on data analytics is also driving how the ATO manages taxpayer risk. The expanded use of the reportable tax positions (RTP) schedule (noting that for the 2019-2020 income year, companies falling in the category of large private groups will now be required to lodge the RTP schedule), the ever-expanding international dealings schedule, the compulsion to lodge financial statements for certain taxpayers, and an ever-expanding list of third party data that the ATO now has at its fingertips, means getting it right from the start is key.
Below we set out some of the key ATO areas of focus as they relate to the private market population.
Privately owned and wealthy groups – Top 320 program
The Top 320 private groups tax performance program is an engagement and assurance approach under the ATO’s Tax Avoidance Taskforce. It involves intensive one-to-one engagement with a focus on prevention rather than correction of tax disputes for these groups.
It is worth noting that the ATO received an additional $1b in funding for the next four years to expand its Tax Avoidance Taskforce, which includes the Top 320 program for private groups. So, expect a well-resourced ATO if they come to review your affairs.
The Top 320 private groups are identified using the following turnover and net asset criteria:
- groups with >$350 million turnover, regardless of net asset value
- groups with >$500 million net assets, regardless of turnover
- groups with >$100 million turnover and >$250 million net assets
- market leaders or groups of specific interest.
Interactions with Top 320 taxpayers are tailored, considering the following factors:
- the taxpayer’s overall tax and economic performance
- the existence of a tax governance framework and the practical use of that
- existing ATO dealings currently underway
- the transactional nature of the client’s business
- areas highlighted in the ATO’s publication What Attracts Our Attention
- the taxpayer’s compliance history
- areas within the taxpayer’s business that have historically generated tax risk
- the level of cooperation and transparency.
Main areas of attention include:
- tax or economic performance, which is not comparable to similar type businesses
- low transparency of tax affairs
- large, one-off or unusual transactions, including the transfer or shifting of wealth
- aggressive tax planning
- tax outcomes inconsistent with the intent of the tax law
- choosing not to comply, or regularly taking controversial interpretations of the law, without engaging with the ATO
- lifestyle not supported by aftertax income
- accessing business assets for tax-free private use
- poor governance and risk management systems.
Some specific areas of interest in the privately owned wealthy groups market
Deductions claimed for bad debts, in particular:
- the genuine nature of bad debts
- whether it is correct to treat the debt as bad
- arm’s length treatment of debts within closely held groups – whether there is debt forgiveness
- the treatment, by related entities, of income reflecting the debt
- the documentation and evidence supporting the claims.
Correct application of the deduction rules, in particular:
- the period when the debts were written off
- the amount being claimed
- whether there is a lending business, or whether the debt is included in income.
Commercial debt forgiveness
Situations that attract attention include entities that have:
- had a debt forgiven (whether formally or informally)
- a commercial debt forgiven, but the gain it represents for the debtor has not been recorded correctly in the tax return
- had a deemed forgiveness that takes place when a debt is assigned to a party related to the debtor
- entered into a debt for equity swap and failed to adjust their loss claims.
Capital gains and losses
Areas of concern include:
- magnitude of capital losses
- calculation of the capital gain – inappropriate accessing of the small business concessions, cross-referencing third party data information (eg State Revenue Office data)
- failure to lodge the CGT schedule with the income tax return.
Private assets or private pursuits in business
This includes assets and private pursuits that generate deductions or are misrepresented as business activities. These deductions reduce profits from other enterprises or income within the same private group structure.
It also covers assets or pursuits that are not accounted for under Division 7A or fringe benefits tax.
Situations that attract the ATO’s attention include:
- private aircraft ownership or activities
- art ownership and dealings
- car or motorbike racing activities
- luxury and charter boat activities
- enthusiast or luxury motor vehicles
- grape growing and other farming pursuits
- horse breeding, racing and training activities
- holiday homes and luxury accommodation provision
- sporting clubs and other activities involving the participation of the principals of private groups or their associates.
Private company benefits
This covers arrangements that enable the extraction of wealth from private companies while avoiding the appropriate amount of tax. These may include:
- excessive or non-arm’s length payments
- director loans
- dividend access share schemes
- Division 7A – deemed dividends
- transactions through interposed entities
- unpaid trust entitlements
- unitisation arrangements.
Taxation of financial arrangements (TOFA)
TOFA issues attracting ATO attention include:
- exceeding a TOFA threshold, but not applying the TOFA rules
- not reporting TOFA gains and losses correctly on the tax return, which may lead to an incorrect PAYG instalment rate being issued
- failing to bring to account accrued but unrealised gains on debt-like securities such as discounted bonds; this rule applies to all taxpayers and is not limited to those subject to the TOFA rules
- failing to use market values for transfers of financial arrangements between related parties
- improper characterisation of a financial benefit as sufficiently certain for the purposes of the TOFA accruals methods.
Areas of concern include:
- corporate groups that restructure and have one or more consolidated groups within a private group
- where multiple entities join or leave the consolidated group
- incorrectly reporting capital gains or losses arising from the allocable cost amount (ACA) calculation and allocation process on joining or leaving the consolidated group; for example, a head company not reporting a capital gain when a negative ACA occurred from an entity leaving the group
- restructuring that may affect the ACA calculation, before joining, forming or leaving a consolidated group
- on joining a group:
- miscalculating or overstating the ACA; examples include the costs of membership interests or the accounting liabilities of the joining entity
- inappropriately including or excluding assets before allocating the ACA to assets
- incorrectly allocating the ACA to assets, which results in increased revenue deductions or cost bases of CGT assets; examples include using inappropriate market values or incorrectly making relevant adjustments
- on leaving a group:
- incorrectly calculating the ACA; for example, by excluding or understating liabilities
- incorrectly allocating the ACA to the membership interests and treatment of pre-CGT (before 20 September 1985) shares (if any)
- formation of a consolidated group and the eligibility of members
- whether the available fraction has been correctly calculated and the losses correctly used.
Situations attracting attention include:
- disposing of the demerged entity or business after the demerger event
- shareholders acquiring more than their share of the new interests in the demerged entity
- schemes aiming to inappropriately obtain CGT rollover concessions through a corporate restructure that does not satisfy the demerger requirements
- demergers that appear to have been undertaken to obtain a tax benefit rather than to improve business efficiency
- demergers that eliminate or significantly reduce assessable capital gains or dividends.
Areas to consider:
- royalty withholding tax obligations upon the use or exploitation of intangible assets and the interactions with transfer pricing
- failure to comply with the new hybrid mismatch rules, with most changes taking effect from 1 January 2019
- failure to lodge the international dealings schedule where required
- failing to report or under-reporting attributable foreign income
- deducted overseas interest and royalty payments made but no corresponding withholding tax paid
- awareness of the significant global entities (SGEs) regime and the obligations (including reporting) imposed upon these entities – country by country reporting, the provision of general purposes financial statements, the Multinational Anti Avoidance Rule (MAAL), and the application of the diverted profits tax (DPT)
- changes in tax residency and frequency.
Property and construction
Situations to consider:
- entities that use a self-managed superannuation fund (SMSF) to fund the development and subdivision of properties, leading to an eventual sale
- property that has been disposed of shortly after the completion of subdivision, where the amount is returned as a capital gain rather than on revenue account
- where there’s a history of property development or renovation sales in the entity’s wider economic group, but the current sale is returned as a capital gain
- an entity that is a landowner and has related entities that undertake a property development
- claiming inflated deductions for property developments that are not in accordance with the trading stock provisions
- an entity that undertakes multipurpose developments with both revenue and capital purposes; for example an entity that retains units for rent after development; the entity needs to make sure that costs are allocated appropriately.
Research and development tax incentive
Four industries of concern have been identified:
- building and construction
- software development.
Behaviours of concern are:
- claiming the R&D tax offset on business as usual expenses
- apportionment of overheads between eligible and non-eligible R&D activities
- payments to associates
- whether or not expenses have been incurred
- approaches taken by R&D consultants
- fraudulent claims
- failure to keep records.
Areas of concern include:
- capital loss trust moved into group
- circular trust distributions
- distributions to complying superannuation funds
- distributions to tax-preferred beneficiaries
- differences between distributable and net income
- family trust distributions tax
- income versus capital
- potential reimbursement agreements
- revenue loss trust moved into group
- value extraction – luxury assets
- value extraction and corpus distributions.
Now is a critical time to revisit key events and material transactions in your business to determine how they are to be reported for tax purposes.
ATO scrutiny has increased in recent times, and it is essential to ensure that you have the right tax processes in place from the outset. Paying attention to your tax governance also ensures that you can defend any scrutiny that does arise.
For more information or to discuss any issues, please contact Michael Kohn
This article is not intended to be advice and should not be relied upon in such a capacity. Cornwalls recommends that you seek proper legal advice regarding these matters, suitable to your particular circumstances.